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“If
countries do not plan for an orderly integration with the world economy, the
world will integrate them in a manner which gives them no control over events.
Thus, the question is not whether a country should or should not move to
capital account convertibility, but whether an orderly or a disorderly
transition is required.” — SS Tarapore, former deputy governor, Reserve Bank of
India

SS Tarapore, a former deputy governor
of the Reserve Bank of India (RBI), passed away on February 3, 2016. He wore
multiple hats — writer, columnist and teacher — apart from being a
dyed-in-the-wool macro-economist and central banker. He was well known for his
views on full capital account convertibility (FCAC). It is as a mark of respect
that we revisit the issue of FCAC for India.

The Reserve Bank of India has been
contemplating permitting FCAC — an important step that would bring about many
changes through liberalization of the use of foreign exchange as well as
domestic currency. At the same time, one is left wondering whether India is
ready for such a move, considering the impact on movement of capital, volatility
of exchange rates and potential disruption of overall macroeconomic stability.

In the recent foreign policy adopted by
the government, India aims to be made an integral part of the global trade
system by 2020. Given this background, Capital account convertibility (CAC)
emerges as a key factor in determining the feasibility of trade between
countries.

Integral to the monetary policy of any
economy, CAC defines the ease with which financial assets may be converted into
those of a different currency. Simply put, flexibility in capital account would
ensure no restrictions exist on foreign investments with respect to ownership
of assets or purchasing of capital — factors commonly involved with phenomena
such as real-estate bubbles or setting up subsidiaries in other countries. A
flexible capital account would also involve the ability to convert domestic
into foreign currency for a resident to purchase a foreign asset, and vice
versa.

Investment
Flow

CAC enables movement of foreign capital
into the country, paving the way for foreign direct investment (FDI) into
domestic projects and portfolio investment in the capital market. With the
investments comes access to a global pool of resources and technological
advancements.

Lifting capital restrictions could be looked
at as a policy measure or incentive to bring about more macroeconomic prudence
and stability. This could all potentially result in a stronger domestic and
even international economy, as India may expand its market share in foreign
economies, receive better returns and possibly experience more progressive
policies overall with foreign exposure to the reform processes. Flexibility in
the capital account can thus accelerate the economy of an emerging market.

Indian policymakers have until now
maintained certain restrictions on asset inflows and outflows: on foreign
investors, on resident Indians, and on companies wanting to borrow or spend
money abroad.

As part of the reforms process in
India, triggered by the balance of payments crisis in 1991, and since 1994, the
Indian rupee has been convertible on the current account. Many types of
controls have since been replaced. The currency is no longer pegged. FDI norms
have been significantly eased. For foreigners and non-resident Indians, there
is an equal and reasonable amount of convertibility in India, despite the
persistence of several procedural restrictions.

Concerns
from Abroad

While FCAC is desirable in principle,
events elsewhere have been discouraging and lead some to believe that an open
capital account invites economic crisis, and closed capital accounts ensure
security.

The Asian financial crisis of 1997-98
saw easy and hazardous fleeing of capital from the country, which severely
hampered the economy. During the crisis, Thailand, Indonesia, South Korea
(followed by Hong Kong, Laos, Malaysia and the Philippines) were severely
affected; India was relatively insulated because of a stabilization policy that
involved restrictions on capital flows.

The ‘Grexit’ fiasco also resulted in
harsh capital controls.

Globalization and risks of contagion
are almost inescapable today. Not to miss the bus on globalization, yet remain
insulated from crisis due to the contagion effect, is a task, not many would
envy.

As India’s economy grows, FCAC is
regarded as inescapable, and resisting it would be futile and
counterproductive. Much more macroeconomic management and safeguards would be
required to facilitate this movement.

Preparatory
Steps

Most evidence points to the
inevitability of full capital account convertibility in the near future, and
thus the focus must be on the need for better preparation. The RBI has been
creating prudential regulations for a framework to guide, monitor and enforce
FCAC in India.

However, many things must be kept in
mind before FCAC is undertaken, such as monetary policy, fiscal and foreign
trade balance and, in the Indian context, banking system reforms. Strong
macroeconomic stability is required before implementing full convertibility,
especially to withstand global shocks.

As the late Deputy Governor Tarapore
envisioned, FCAC must be implemented in an orderly fashion, taking into account
all risks and other influencing factors, along with a well-researched,
holistically-approached analysis of its impact on the Indian market, informed
by successful policies and paradigms in other countries and supervision by
analysts and committees from the field.